Pareto Principle
Purpose
The Pareto Principle, also known as the 80/20 Rule or Power Law describes a fundamental law of nature where a minority of inputs are often responsible for a vastly disproportionate share of outputs.
At the turn of the 20th century, many bloody and violent revolutions had brought about a new sense of progressivism in the world, where the ideals of Democracy (or its counterpart Communism) were finally starting to take root in place of a more concentrated, tyrannical ruling elite.
However within this swirl of radical change, a counter intellectual movement was emerging in Italy, what we now label neo-Machiavellianism, a counterweight to the fundamental ideals of freedom and equality.
This movement was seen as the heir to the legacy of the father of political science, Niccolò Machiavelli - and for its similar ability to maintain a cold and unsentimental approach to the study of power structures and politics, and an acceptance of its true, harsh realities.
The core proposition of this group was that a minority would always rule over the majority.
Once this concept was understood and accepted, the key question then became strategic - understanding the means by which the elite sustain their position of power, and how this power ultimately might be displaced by a new elite.
The most famous proponent of neo-Machiavellianism was Vilfredo Pareto, a sometimes engineer, economist, sociologist, political scientist and philosopher.
Pareto became fascinated with the study of data on income distribution and land ownership throughout different countries and centuries, and how society rarely, if ever, followed a “social pyramid” with the proportion of rich to poor sloping gently from one class to next.
What he found instead was that a minority of inputs could be responsible by a vastly disproportionate share of outputs.
From this he defined his Pareto Principle - that 80 percent of effects came from about 20 percent of the causes.
Pareto also subscribed to a theory of social equilibrium - that societies were inherently resistant to change. When disturbed by internal or external forces (from regulation change all the way through to violent revolution) a counteracting movement would invariably develop, pulling the society back towards its original state. A sort of invisible expansion and contraction above and below a point of perceived equilibrium.
In other words, universal fairness was a utopian pipe dream.
Even our modern day democracies create this illusion, with party candidates decided upon in smokey back rooms separate from the voting public, and a ruling subset who tend to always emerge to use their political positions to enrich themselves or their families.
Pareto and Management Consulting
In the 1940’s, Management Consultant Joseph M. Duran first introduced the Pareto Principle to the world of business. In the 1960’s, consultant Richard Koch further expanded upon the application of this theory, in his book ‘The 80/20 Principle’, which provided more tangible lessons to be applied to organizations and strategy.
The three primary taskeaways of the book were simple:
People expect things to be fair and balanced, but they are not, largely due to feedback loops
The most important aspect any business can optimize is their product range
The exact Pareto ratio is illustrative, rather than exact
Principle 1: Feedback Loops
The first principle asks us to put away the idea of linearity and 'fair and balanced'. Nature is not fair, so it holds that power structures within the business world will also not be fair - and evolutionary theory in the form of feedback loops are the fuel to the fire of this inequality.
The type of feedback loop we are referring to is probably expressed as simply as possible as the statement ‘success breeds success’. Outputs become the inputs in the next cycle, compounding information and learnings to give the entity further advantages over those it competes with.
So while having a strong castle & moat and a strategy for laddering are important, the playing field is rarely equal as organizations develop feedback loops that give then an unequal advantage.
Feedback Loops have especially become lynchpins in tech thanks to Aggregation Theory, or in practical application, through Human Centered Design techniques like the Build-Measure-Learn or the Design Sprint process.
Principle 2: Product Range
The second principle is all about focus and incentives, specifically in relation to optimization of a business' product range. When analyzing companies, Koch noticed that often the top 2-3 products tended to result in well over 50% of the revenue.
By narrowing down the product line to just these best-sellers, the business could be more lean, more focused, and ultimately grow through simplification.
Apple are probably the most famous proponent of this principle, with Steve Jobs pairing down their 300+ product line to less than 10 on his return to the company in 1997, bringing it back from the brink of bankruptcy to the powerhouse it is today.
Principle 3: Ratio as Illustrative
The last principle from Koch was to not take the ratio of 80/20 too literally. To do so would be to fall into a trap of logical fallacy.
It is mere coincidence that the variables of 80 and 20 happen to equal 100% neatly. Inputs and outputs represent different units, so 78% of the output might come from 36% of the inputs - plausible even though the total equals 114%.
You should also never assume that because 20% of inputs are important, that the other 80% must be unimportant.
Pareto and Venture Capital
Beyond the rise of Management Consulting in the 1960’s, the Pareto Principle began to be seen as a phenomenon in tech.
The first instance was within software development. Microsoft became aware of and started to factor in the 80/20 rule as part of its development process - by fixing 20% of the most reported bugs, 80% of the related errors and crashes within a system would be eliminated. This law would become a staple in planning out the coding process.
Where the principle has now fundamentally found its spiritual home is in the Venture Capital industry, in what is commonly known as the Power Law of VC.
Both Venture Capital funds and the startups they invest in are extremely risky, and the reality is the vast majority of startups fail, leading to the failure of most venture funds (a sort of negative feedback loop).
The big error lies in the expectation that venture returns will be normally distributed. Again, believing in fair and balanced is the biggest trap. Traditional investments assume that bad companies fail, mediocre investments may stay flat, and good investments may return two to four times what was put in. Applying this mindset to VC is the route to failure.
Peter Thiel is a massive proponent of this theory, as outlined in his book ‘Zero to One’. As he states;
“The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined."
This is further exemplified in his rules for VC:
Only invest in companies that have the potential to return the value of the entire fund. This eliminates the vast majority of potential investments.
Second, because rule number one is so restrictive, there can be no other rules.
Every company must have the potential to succeed at vast scale.
While this may sound hugely restrictive in many ways, tech companies have the power to become massive aggregators, harness network effects, reach vasts pools of customers across borders, and often have zero marginal costs - these factors mean that winning a bet means you win incredibly big.
Creating a Pareto Advantage
So how can you leverage the Pareto Principle to give yourself a ‘Pareto Advantage’?
The biggest lesson is to accept the harsh reality that things are fundamentally distributed equally, once you do this you can use the principle to fine tune your focus.
As Jim Barksdale was fond of saying;
“The main thing is to keep the main thing the main thing.”
One market will probably be superior to all others.
One distribution or marketing strategy will usually dominate all others.
One set of products or a client subset will likely dominate.
One subset of your decision making process will likely result in the greatest output.
With this in mind, make it a habit of auditing your environment (both organizational and personal) to examine which inputs are creating the biggest output advantage.
For example;
If you are starting out on a new venture, rather than throwing the kitchen sink at every distribution opportunity, test which channel(s) provide the best power advantage, and double down. Maintain a focus on what works.
Analyze your client base, and apply the Tim Ferriss '4-Hour Work Week' rule - once you have identified the 20% who deliver the most profits, fire the other 80% so you can over serve the first set and free up your focus.
Lastly, your time and attention will follow a power law, so use this as a personal audit of your own behavior. For example, if you are in an advisory or management position, use the rule as a self-awareness monitor and try and listen 80% of the time and only speak 20% of the time.
Or apply it to busy work versus creative work - block off 20% of your time away from things like email and your phone so you can knuckle down and focus on productive work that will most often end up being what delivers the most value.
The world isn't distributed fairly. But by understanding the Pareto Principle, you can ensure you make this work to your advantage.
Author's note, all frameworks are inherently flawed, so apply them wisely. The utility of a framework is always dependent on the individual problem at hand.
